Ask the Expert: Pay Off Debt AND Fund Your IRA
by Walter Updegrave
Tuesday, January 15, 2008
provided by CNNMoney.com


Question: I pay $300 a month on my credit-card balance of roughly $11,000. I have an extra $350 a month that I can use to further reduce my credit-card balance, or that I can invest in a Roth IRA. Which will give me the biggest bang for my buck? - William Scott, Spotsylvania, Virginia

Answer: The short answer is that you would almost certainly be better off using the extra dough to pay off your credit-card balance.

That said, however, this is one of those areas where the best deal in the strictest financial sense may not necessarily be the best real-world solution.

To see what I'm getting at, let's run through a scenario using the figures you've given me, and then I'll explain why you might not want to make your decision purely on the numbers.

You don't mention what interest rate you're paying on your credit card, but for argument's sake let's assume that you pay 14 percent a year, which is roughly the national average. As for the Roth IRA, let's figure that you earn 8 percent a year, not a spectacular return, but a reasonable one assuming you invest in a diversified mix of stocks and bonds.

Investing extra dollars

Let's first look at the scenario of you continuing to pay $300 a month on your credit card and then investing the extra $350 in a Roth IRA.

At a payment rate of $300-a-month, it will take 49 months to wipe out an $11,000 balance on a card that charges 14 percent a year, according to the credit-card calculator at Bankrate.com. Actually, your last payment will be just over $38, leaving you with just under $262 of the $300 you set aside for that final payment.

Now, if at the same time you're paying $300 toward your credit card bill, you also contribute $350 a month to a Roth IRA that earns 8 percent a year, after 49 months you will not only have a zero credit card balance, you will also have investments worth $20,215 sitting in your Roth IRA account.

And if we assume you're conscientious enough to throw in the $262 or so you had left from your last credit card payment - and that you earn a month's return on that money - then your Roth IRA balance would total $20,479.

Not bad. But let's see how you would fare if you had instead paid off the credit card as quickly as possible and then funded the IRA.

Paying off debt

In that case, you would devote $650 a month to the credit card - your current $300, plus the extra $350. At that payment rate, you would clear your balance in just 19 months. Your final payment would be just under $626, leaving you with about $24.

If you then started plowing $650 a month into a Roth IRA for the next 30 months - and earned an 8 percent annual return on that money plus the $24 left over from your final credit card payment - you would have a Roth IRA balance of $21,601 at the end of 49 months.

Bottom line: you would come out ahead by $1,122 by using all your cash to pay off the credit card first and then funding the Roth IRA.

This result isn't too surprising, of course. By paying off the credit card first you're reducing the amount of time you're being hit with a 14 percent annual interest charge. That's effectively the same as earning 14 percent, which is more than you're earning on the money you put in the Roth IRA. (Of course, you could arrive at the opposite result by assuming you'll earn more than 14 percent on your Roth IRA investments, but I think that would be unrealistic.)

Downside of clearing balance

As I said earlier, however, I believe there's a potential hitch in the strategy of waiting to fund the Roth IRA until after you've zeroed out your credit-card balance. My concern is that you might never get around to paying off your credit card. Sometime over the year-and-a-half or so, you could lose the resolve to clear that debt and begin finding other ways of spending the extra $350 a month.

In short, I worry that someone in your position who embarks on the "best" strategy might find themselves a year or two later still owing substantial credit-card debt but never having gotten around to funding the Roth IRA.

That's why I think the less-than-ideal strategy of continuing to pay off the credit card, but simultaneously plowing money into the Roth, might actually be the better way to go since that approach at least gets the Roth IRA up and running quickly.

Upside of funding Roth IRA

Granted, this strategy can also fizzle. I could easily imagine someone making just a few of Roth IRA contributions and then neglecting to follow through in subsequent months. But starting the Roth right away while you've got the urge to improve your situation might get you into the habit of saving regularly (especially if you sign up for an automatic investing plan that moves money regularly from your checking account to a mutual fund). And even if that doesn't happen, well, at least you'll have some money in a Roth IRA that can come in handy at retirement.

So my advice is that if you're really, really sure that you've got the discipline to pay off your credit card and then fund that Roth IRA, go for the "best" strategy.

But if you're not positively absolutely sure, then I think it's a perfectly acceptable strategy - and probably the more sensible choice - to pursue both goals at once and pay off your credit card while funding the Roth IRA.

Debt free is best

By the way, for those of you out there wondering whether you're better off devoting extra cash to your credit card or your 401(k), the answer is basically the same. Based on the numbers alone, you're generally better off eliminating the credit card debt first, although matching funds within a 401(k) can complicate things.

Of course, an even better strategy for achieving financial security and assuring yourself a comfortable retirement is to avoid running up unnecessary and burdensome credit-card debt in the first place. That way, you can funnel whatever money would have gone to pay the debt on your plastic directly into your 401(k) or IRA.

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